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A Tale of Two Effects

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  • Paul Evans

    ()
    (Department of Economics, Ohio State University)

  • Xiaojun Wang

    ()
    (Department of Economics, University of Hawaii at Manoa)

Abstract

This paper adopts a New Keynesian approach to analyze the relationship between nominal interest rates and prices. In this new framework, both a positive relation between interest rates and price levels (i.e., a positive Gibson effect) and a negative relation between interest rates and subsequent price changes (i.e., a negative Fama-Fisher effect) arise when money is supplied inelastically and prices are flexible. Such an economy is subject to Gibson’s Paradox, a long-standing puzzle in monetary economics, and a novel paradox identified here, a Fama-Fisher Paradox. By contrast, economies characterized by elastic money and sticky prices are not so paradoxical since nominal interest rates are positively related to subsequent inflation and ambiguously related to the price level. Empirical analysis of nearly two centuries of data for ten countries supports the new theory.

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File URL: http://www.economics.hawaii.edu/research/workingpapers/WP_05-6.pdf
File Function: First version, 2004
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Bibliographic Info

Paper provided by University of Hawaii at Manoa, Department of Economics in its series Working Papers with number 200506.

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Length: 35 pages
Date of creation: 2005
Date of revision:
Handle: RePEc:hai:wpaper:200506

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Keywords: Fama-Fisher Paradox; Gibson’s Paradox; inelastic money; flexible prices; gold standard;

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References

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  1. Barsky, Robert B & De Long, J Bradford, 1991. "Forecasting Pre-World War I Inflation: The Fisher Effect and the Gold Standard," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 815-36, August.
  2. Dwyer, Gerald P, Jr, 1984. "The Gibson Paradox: A Cross-Country Analysis," Economica, London School of Economics and Political Science, vol. 51(202), pages 109-27, May.
  3. Sargent, Thomas J, 1973. "Interest Rates and Prices in the Long Run: A Study of the Gibson Paradox," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 5(1), pages 385-449, Part II F.
  4. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-82, June.
  5. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc.
  6. Barsky, Robert B & Summers, Lawrence H, 1988. "Gibson's Paradox and the Gold Standard," Journal of Political Economy, University of Chicago Press, vol. 96(3), pages 528-50, June.
  7. Klovland Jan Tore, 1993. "Zooming in on Sauerbeck: Monthly Wholesale Prices in Britain 1845-1890," Explorations in Economic History, Elsevier, vol. 30(2), pages 195-228, April.
  8. Robert B. Barsky, 1986. "The Fisher Hypothesis and the Forecastability and Persistence of Inflation," NBER Working Papers 1927, National Bureau of Economic Research, Inc.
  9. Roll, Richard, 1972. "Interest Rates on Monetary Assets and Commodity Price Index Changes," Journal of Finance, American Finance Association, vol. 27(2), pages 251-77, May.
  10. Hafer, R W & Jansen, Dennis W, 1991. "The Demand for Money in the United States: Evidence from Cointegration Tests," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(2), pages 155-68, May.
  11. Wicksell, Knut, 1907. "The Influence of the Rate of Interest on Prices," History of Economic Thought Articles, McMaster University Archive for the History of Economic Thought, vol. 17, pages 213-220.
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Cited by:
  1. Francesca Di Iorio & Stefano Fachin, 2009. "A residual-based bootstrap test for panel cointegration," Economics Bulletin, AccessEcon, vol. 29(4), pages 3222-3232.
  2. Cheng, Hao & Kesselring, Randall G. & Brown, Christopher R., 2013. "The Gibson paradox: Evidence from China," China Economic Review, Elsevier, vol. 27(C), pages 82-93.

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